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What is the 4% Rule? - Pinnacle Investment Management, Inc.

What is the 4% Rule?

November 29, 2016 / Blog


One of the most important questions for a retiree is “How much income can I safely withdraw from my portfolio without running out of money?” Answering this question is anything but simple, as it requires an analysis of a number of different unknown factors, including expected longevity, future portfolio returns, and your spending needs in retirement.

One attempt at answering this question leads to one of the more popular retirement rules of thumb: The 4% Rule.



The question of how much a retiree could safely withdraw from their portfolio started to arise in the early 1990’s. At that time, the financial press was suggesting that since stocks averaged about 7% a year after inflation, a retiree could safely withdraw 7% a year from their portfolio in retirement.

Seeing some issues with this reasoning, William Bengen, a Financial Planner in California, wanted to test what withdrawal rates were sustainable by looking at historical stock and bond market returns. Testing different withdrawal rates on hypothetical retirees with portfolio’s of between 50-75% stock all the way back to 1926, Bengen concluded that the safe withdrawal rate was around 4%.

The 4% rule provides that a retiree can take out as income 4% of their initial portfolio value at retirement, adjust that amount by inflation every year, and the portfolio should last at least 30 years (30 years being the common assumption of how long a retirement may last). The 4% rule was intended to provide a stable, inflation adjusted income stream for a retiree that, based upon historical stock and bond returns, could be sustained for 30 years.

An important point to understand is that the 4% withdrawal only applies to the first year of retirement. In that first year, the 4% rule sets the income amount, and that amount is static from year to year, besides for the inflation adjustments. The income amount doesn’t respond to how the portfolio is performing.

Jim retires at age 65 with a $1,000,000 portfolio. Based upon the 4% rule, Jim can initially take $40,000 from his portfolio. If inflation is 3%, then in the second-year Jim will take $41,200 ($40,000 x 3% inflation). This will continue every year, and based upon historical market returns, Jim’s portfolio should last until he is 95.

Sequence of Returns Risk

So why is the withdrawal rate so low when the average return for stocks is about 7%? This leads us to one of the most important findings from the work done by Bengen: sequence of returns risk.

A retiree cannot just withdraw the average return of their portfolio because of volatility. As everyone knows, stocks and bonds do not return a set amount every year. Rather the returns can vary quite a bit from one year to the next.

The sequence of returns risk illustrates that the market results that a retiree experiences early in retirement have a disproportionally large impact on the success of their retirement portfolio.

As a general example of how poor market returns early in retirement can impact a retiree:

Mary is 65 and recently retired. She has $1,000,000 saved and needs to withdraw $60,000/year from her portfolio to meet her spending needs. She is counting on good market returns to sustain her 6% withdrawal rate.

Unfortunately, in her first year of retirement, the markets decline and by the start of her second year in retirement, her portfolio has gone down to $850,000. In the second-year she withdraws $61,800 ($60,000 x 3% inflation). She is now withdrawing 7.3% from her portfolio ($61,800/$850,000).

In the 3rd year of retirement, the market performs poorly again and her portfolio is now down to $750,000. She withdraws $63,650 ($61,800 x 3% inflation). Now her withdrawal rate is 8.5%. Unfortunately, Mary may deplete her investment portfolio early since she experienced poor market returns early in retirement and chose too high of an initial withdrawal rate

While this is just a crude example ­—and in reality Mary could adjust her spending— it does show how important the sequence of returns are for a retiree.


The Good and The Bad

The 4% rule is based on various assumptions. How applicable the 4% rule will be for a retiree depends partially on how they view these assumptions.


  1. The 4% rule assumes a 30-year lifespan. Obviously everyone isn’t going to live exactly 30 years. Some will live longer, and some won’t. If you plan for living 30 years in retirement (or shorter), what happens if you live beyond those 30 years? Longevity is a key concept to understand when planning for retirement.


  1. The 4% rule assumes that a retiree will spend a set, inflation adjusted amount every year. In reality, most retirees will not spend a static amount from one year to the next. Research has shown that most retirees will spend more in the early years of retirement, and then will start to spend less in the middle and later periods.


  1. The 4% rule assumes the worst-case scenario from historical results. As the following chart from retirement researcher Wade Pfau demonstrates, the safe withdrawal rates for most historical retirees was much higher than 4%. The only retirees that would have needed to rely on the 4% rule were the retirees in 1966, who unfortunately retired into a decade of poor market returns and high inflation.


pfau-4On the other hand, retirees that retired in 1975 could have safely withdrawn close to 7% of their portfolio every year without running out of money, as they retired into a sustained period of good market returns.  The 1975 retirees who decided to rely on the 4% rule may have made sacrifices in their spending that they didn’t have to.

One of the obvious challenges with this is that we don’t know what future returns will be. There is an inherent trade-off with the 4% rule of being safe vs. being overly safe.

One key takeaway from understanding the 4% rule is the potential importance of adding flexibility into your withdrawal plan. Recent research has shown that if a retiree has some flexibility in their withdrawals from year to year, they could support a withdrawal rate of over 5.5%.


  1. How much can we rely on historical market returns? This is an area of debate in the financial planning space. Some believe that the safe withdrawal rate properly accounts for poor market returns, since it was tested during times that included the Great Depression, the Second World War, and the high inflation of the 1970’s.

Others believe that there is a lot of risk in assuming that historical results will continue into the future. One issue they raise is that the returns on bonds could be much lower in the future than they were in the past. In the time period studied by Bengen, there was only one year where yields on the 10 year US government bond were under 2%, while we have experienced low bond yields for a number of years now. Many researches believe that current safe withdrawal rates should be as low as 3%.


Final Thoughts

The 4% rule is a rule of thumb that can help a retiree understand, in very general terms, what they may be able to expect from their portfolio in retirement. However, like all rules of thumb, there are issues when trying to apply a broad brush to a rather complicated and individual matter.   There are a number of different withdrawal strategies, and while none of them are perfect, you can tailor one that best applies to your situation.

Like always, I would recommend you work with a Financial Planner to understand all of your income sources in retirement, and then create a withdrawal strategy that best meets your objectives.


Sources & Further Reading
Wade Pfau Retirement Researcher Blog


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About the author

John Shanley: CFP ® is a Financial Advisor with Pinnacle. He joined in 2015 after previously working as a Financial Consultant for Fidelity Investments. John is a Certified Financial Planner, a graduate of Fordham University and is currently pursuing his Masters degree in Financial Services. John is a native of Pawling NY and currently resides in Suffield with his wife, Jennifer, who is an Immigration Attorney. In his free time, John enjoys reading and is an avid hockey fan.

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